Protecting Principal Against Inflation via TIPS

Your friend Karen is concerned about inflation increasing so she purchases $1,000 of a Treasury Inflation Protected Securities (TIPS) bond with a semi-annual coupon payment of 2%. TIPS are unique in that the principal amount ($1,000 in this case) will increase with inflation. For example, if there was 3% inflation over the first six months of the bond, the principal amount would adjust to $1,030 ($1,000 x 1.03 = $1,030).

Karen isn't quite certain how the semi-annual coupon payments on TIPS work, so she asks for your help. She thinks inflation will be 2% over the first 6 months of owning the bond and 3.25% for the  six months following. What is the total amount of coupon payments would she get from her TIPS bond over the first year under this scenario?

1. $20
2. $20.53
3. $20.73
4. $20.80

(Answer below...) 

What are Treasury Inflation Protected Securities (TIPS)? 

According to Investopedia treasury inflation protected securities (TIPS) refer to a treasury security that is indexed to inflation to protect investors from the negative effects of inflation. TIPS are backed by the U.S. government and their par value rises with inflation - as measured by the Consumer Price Index - while the interest rate remains fixed.

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Doug's Quiz Corner Treasury Inflation Protected Securities TIPS